In neighborhoods across Chicago, concessions are starting to take hold. After several years of meteoric rent growth—from the downtown high-rises to midtown podium walk-ups to the single-family-for-rent outer rings, the fourth quarter of 2022 witnessed a full stop to one of the best net operating income and asset value growth cycles the Windy City has seen in decades.
“Fundamentals basically fell off a cliff on Labor Day,” says Mike Zucker, who launched Peak Properties in 1998 and has since grown the portfolio to 8,000 units under management with a 15% ownership interest. “We have all kinds of properties, and demand has always been different across the market, but rent just cannot grow to the sky. No matter what kind of asset or neighborhood, we’re definitely entering an era of concessions.”
Indeed, from the Midwest to the Southeast to Texas and the core-plus metropolitan statistical areas on the coasts, 2023 will more than likely mark the beginning of the end of historic rent growth in multifamily. While incremental rent gains are to be expected from shrewd operators and hotter markets this year, signs of a cycle apogee abound, and cycle-tested apartment owners and managers expect a turning point likely to reward long-hold investors with fixed-rate financing and a tight grip on expenses.
In Phoenix, transactions and construction stalled in late 2022 as developers eyed year-over-year depression in effective rent growth and exposure to thousands of units of new deliveries across 2023 and into 2024. After strategically transitioning to a mostly Class A portfolio of 22,000 units under management, of which 5,000 are owned, Scottsdale, Arizona-based Mark-Taylor Residential will use the balance of this year to focus on securing occupancy and stockpiling land for future development.
“The market moved swiftly,” says Mark-Taylor president John Carlson. “At the end of the second quarter last year you could still get your whisper price and close quickly on dispositions. Within 90 days we were seeing guys pull deals off the market, we were seeing retrades, and the institutional and private equity investors went pencils down. As a development group, we were in our last two deals after being active since 2011 but have pulled the parachute and will look to bank our land for the long term.”
Emblematic of apartment markets from coast to coast, Phoenix saw its best operational year on record in 2021, with 20.5% effective rent growth providing strong tailwinds into the first half of 2022 and fueling continued interest from scores of investors eager for immediate cash flow and the promise of can’t-lose arbitrage, particularly from value-add opportunities. “Our investor DNA is as diverse as ever. From institutional and life companies all the way to mom-and-pop, everyone checked green on Phoenix multifamily,” Carlson says. “But in 2021 you had everyone here, and I mean everyone. Groups of investors we’ve never seen before on the tour sheets, obscure groups in late cycle behavior.”
The emergence of new investor groups in the sector hasn’t been limited to Phoenix. Growth in the ranks of high-net-worth individuals has transformed the “country club” class of investors who traditionally plied the market of walk-up onesies and twosies into a cadre of well-capitalized—if not necessarily well-seasoned—buyers. For many of these new investors, particularly those with floating debt and aggressive underwriting expectations, distress is nigh.
“We were in an investment cycle where two or three private guys could cobble together $100 million deals,” says Noah Hochman, co-chief investment officer and head of capital markets for Los Angeles-based TruAmerica. “It’s resulted in a lot of investors in the space that are not cycle tested, have not gone through a downturn, have not dealt with the interest rate environment we see now. Their business was to flip things in 24 months because rents were going to go up and cap rates were going to go down forever.”
The availability of high-leverage, short-term (three- to five-year) bridge money when LIBOR and other key rates were hovering close to zero was a big reason why cap rates compressed so much in 2020 and 2021, Hochman says. As the Fed moved to push benchmark rates higher in order to curb inflation, many of those deals no longer pencil out, and when investors are faced with debt-service covenants, they’ll be forced to either cut a check or sell the underlying asset.
Alex Loo, a vice president and FHA loan originator at Hudson Realty Capital, agrees that smaller, more nascent players will be among those less likely to be able to pay covenant coupons. “We’re in a very different interest rate environment, and we are looking at negative leverage being a real thing,” Loo says. “The institutional folks are well capitalized and will fare fine, but the middle market is where everyone will be looking for the dominoes to fall, and at some point in Q2 or Q3 some deals will no longer make sense. Those investors will either go back to the sponsor and ask for more equity or promise the bank a workout to pay down the debt service and hand them the keys. That will be happening at some point.”
In addition to busted value-add deals coming back to the market, investment funds that need to either place allocations or recoup end-of-fund values is expected to buoy apartment transactions even as cap rates continue to spread. To many, that phenomenon is part of a natural and welcome recalibration, even if yields aren’t as robust as they were at the crest of the market.
Memphis, Tennessee-based Fogelman Properties has grown its portfolio to 31,000 units under management with an ownership interest in 22,000 apartments in the Southeast, Midwest, and Texas. Focused mostly on Class A properties, the company recently hired a new head of acquisitions for Texas and expects opportunities as it deploys its own fund while also making select joint-venture purchases with institutional investor partners.
“Growth-wise, we’re happy in our space and are not shooting to be one of the giants out there,” says Fogelman senior vice president of investments Mike Aiken. “If things hold on the current path, we do expect some opportunities from investors who purchased on high-leverage, floating-rate debt, but we expect at least a few more quarters for those opportunities to hit the market. Until then we see large funds facing redemption requests, and a lot of the volume of what is on the market right now is being sold from those vehicles.”
TruAmerica underwrites a five-year hold into all of its acquisitions with the expectation of flexing to either an opportunistic or conservative posture depending on market conditions and recently just sold two Orlando assets that had exceeded plan.
“Last year an ’80s deal in Albuquerque, New Mexico, and a core deal in Scottsdale were both trading to the same cap, so we are reverting back to a cap rate environment that is more accurately indexed to asset quality, vintage, and location,” Hochman says. “We’re not wed to the values of 2022. When we look at our business plan and still see prices higher than what we underwrote, we’re going to take profit. There’s nothing wrong with doing that, and we’re not trying to time the market. Every deal stands on its own.”
Cutting Costs Instead of Losses
After raising nearly $1 billion for a series of acquisition funds deployed during 2020 and 2021, Greensboro, North Carolina-based Bell Partners will look to focus the balance of 2023 on operations and retention across its 78,000-unit portfolio that the company holds a 30% ownership interest in. Stabilizing lease-ups while fundamentals remain relatively strong will also be a key initiative as Bell gauges the pace of new development in its markets.
“Our investors expect us to take a disciplined approach so we’re mostly pausing on acquisitions for the moment as we still have a fair amount of lease-ups in our markets and a fair amount of lease-ups in the portfolio to work through,” says Bell chief operating officer Cindy Clare. “Getting new development deals to pencil in a high interest rate, high unemployment environment obviously gets harder, so we are looking at how to stabilize and maintain occupancy. Our average retention is 60%, and I want to maintain that because it helps on the expense side as well as the [income] side.”
Softening in loss to lease metrics coupled with price inflation and material availability has many operators seeking to likewise minimize their exposure to turns, further constricting value-add plays as companies look to maximize cash on hand.
“I think we have found a settling point for rents, and as we roll leases to market, loss to lease is something that we’ll look at with expectations of 5% to 7%,” says Pete Petron, managing director of asset management for Norfolk, Virginia-based Harbor Group International, an owner and manager of 57,000 units nationally. “Specifically, we have increased our focus on retention and want to work on renewals early and mitigate move-out exposure. With supply chain and labor challenges we’re seeking to dial back the pace of renovations and are including in our return on cost the additional downtime, so we get paid not just for the upgrade but for the exposure to market, too.”
Back in Chicago, Peak Properties has felt less exposure to turns but nevertheless is looking for solutions to cost containment, particularly as it relates to property management. “We’re always evaluating new technology, including a lot of security technology and identity fraud protection as leasing becomes virtual,” Zucker says. “A lot of those investments are pointing toward offshore solutions. People were getting complacent because there was so much money in the system, but you cannot keep saying yes to increased wages.”
Back to the Beginning
Based on the current pace of development, Mark-Taylor properties are poised to face delivery of an additional 13,000 units after a record 14,200 units came onto the market last year, the most since 1986. “We didn’t really have issues with absorption until [October], but the conversations around loss to lease are increasing, and we’re expecting compressions down to 3% or 4%,” Carlson says. “Getting back to normalcy matters, because when the market gets this hot, there are a lot of reactionary components, including management. You are seeing some fee reduction and desperation to meet growth expectations in the market.”
Despite stressors to the national apartment market and workouts of value-add distress, capital—particularly foreign equity—is expected to continue to flow into the sector, seeking what Carlson calls “deeply rooted” operators who understand how to work the longer-term cycles in multifamily. Cyclically, funds that recalibrate annually will also begin to deploy allocations in the first quarter of the year, catalyzing the deal flow that could ultimately spurn new development.
“Multifamily is still a darling in the world of asset classes, and capital inflows are not going to slow down,” says Loo. “It’s not for everyone, but we believe that strong, experienced sponsorship knows what to do. It’s not uncommon for multifamily to hit a stretch in the cycle that weeds out the not-so-veteran players.”
Hochman points to the growing ask spread between buyers and sellers as another signifier that multifamily is preparing for a cycle turn and, like other operators tightening their belts on expenses and caching dry powder capital to poach distress assets, sees a brighter future for the sector even with tougher fundamentals ahead. “This is all somewhat of a reset, and we think that is probably a good thing, as it gives the market the opportunity to settle down and revert back to more rational levels,” he says. “Cap rates are going to go up, and there will be some troubled deals out there, but we believe investor interest in apartments will remain strong, and the people with smart debt and smart interest rates will rule the day.”